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Securities, Scienter & Schizophrenia: Should the Efficacy of Compliance Pace Law Review Volume 25 Issue 2 Spring 2005 The Anti-Terrorist Financing Guidelines: The Article 9 Impact on International Philanthropy April 2005 Securities, Scienter & Schizophrenia: Should the Efficacy of Compliance Initiatives within Multi-Service Investment Firms Be Used to Determine Scienter for 10b-5 Violations Under Federal Securities Law? David Ian Wishengrad Follow this and additional works at: https://digitalcommons.pace.edu/plr Recommended Citation David Ian Wishengrad, Securities, Scienter & Schizophrenia: Should the Efficacy of Compliance Initiatives within Multi-Service Investment Firms Be Used to Determine Scienter for 10b-5 Violations Under Federal Securities Law?, 25 Pace L. Rev. 383 (2005) Available at: https://digitalcommons.pace.edu/plr/vol25/iss2/9 This Article is brought to you for free and open access by the School of Law at DigitalCommons@Pace. It has been accepted for inclusion in Pace Law Review by an authorized administrator of DigitalCommons@Pace. For more information, please contact [email protected]. Securities, Scienter & Schizophrenia: Should The Efficacy Of Compliance Initiatives Within Multi-Service Investment Firms Be Used To Determine Scienter For 10b-5 Violations Under Federal Securities Law? David Ian Wishengrad* I. Introduction ................................................................................ 383 II. Brief Overview of the Federal Securities Laws ......................... 386 III. The Evolution of Compliance from Voluntary Process to Legal Requirem ent ..................................................................... 391 IV. Compliance as a Source of "Organizational Scienter ................ 398 V. Assessing Organizational Scienter ............................................. 400 V I. C onclusion ................................................................................. 404 I. Introduction Over the past few years, in reaction to widespread corporate malfeasance, compliance initiatives within large corporations have received significant attention. Private corporations, public regulatory and enforcement agencies, and Congress, all recognize that compliance plays a critical role in today's highly complex business environment.' Nearly all of the nation's public companies maintain compliance programs that formulate corporate rules and policies in response to industry regulations and applicable laws.2 Recently, Congress passed the * David Ian Wishengrad is a J.D. candidate at Pace University School of Law, class of 2005. He graduated from Duke University with an A.B. in Psychology. He also received a M.B.A. in Finance from New York University Leonard N. Stem School of Business. 1. See, e.g., Memorandum from Deputy Attorney General Larry Thompson, to the Heads of Department Components and United States Attorneys (Jan. 20, 2003), available at http://www.usdoj.gov/dag/cftf/corporate- guidelines.htm. In this January 2003 policy memorandum, federal prosecutors are urged to review several factors before indicting a corporation. These elements include (1) the nature and seriousness of the behavior; (2) the pervasiveness of corporate wrongdoing; (3) the corporation's history of similar conduct and prior enforcement actions against it; (4) the voluntary disclosure of wrongdoing; (5) the existence and adequacy of a corporate compliance program; (6) remedial actions; (7) the collateral consequences of a conviction; and (8) the sufficiency of civil remedies for the corporation's conduct. Id. 2. Id. 1 PACE LAWREVIEW [Vol. 25:383 Sarbanes-Oxley Act of 2002 due, in part, to a need for more responsible corporate governance.3 The Act, though covering a wide spectrum of governance issues, significantly increases the importance of compliance programs and directly implicates the efficacy of compliance initiatives as determinative of corporate accountability.4 The new body of law guiding corporate compliance is bound to have a profound effect on the behavior of large complex organizations. The modern corporation seeks to optimize future performance by assessing how well it interacts with its environment (e.g. customers, competitors, and regulators).5 As organizational behaviorist Jay Galbraith states, sophisticated "organizations typically find ways of controlling outputs (e.g. by setting goals and targets) and controlling behavior (e.g. through rules and programs) by relying on continuous feedback.",6 The ability to process external information and adjust behavior to meet corporate objectives, has led many scholars to view the corporation as an organic-like being with a "centralized brain that regulates overall activity.",7 In this regard, sophisticated corporations exhibit complex decision-making processes akin to those found in humans.8 While organizational behaviorists have readily accepted that sophisticated corporations are entities engaged in rational-based decision-making and, as such, readily exhibit identifiable behavior, to this day the law has not fully embraced this concept. 9 Unlike the philosophical underpinnings that have helped shape our notions of applying fault-based law to "natural" persons, the theoretical basis of corporate fault relies heavily on the doctrine of imputed liability, 3. See Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204 (2002). 4. Id. at § 501. 5. See KARL E. WEICK, SENSEMAKING IN ORGANIZATIONS 121-122 (1991). ("[Organizations] filter and interpret signals from the environment and tie stimuli to responses. They are metalevel systems that supervise the identification of stimuli and the assembling of responses." (quoting B. Hedberg, How OrganizationsLearn and Unlearn, in HANDBOOK OF ORGANIZATIONAL DESIGN, 7-8 (P.C. Nystome & W.H. Starbuck ed. vol. 1))). 6. GARETH MORGAN, IMAGES OF ORGANIZATION 80 (1996). 7. Id. at 78. 8. Id. 9. See, e.g., Nordstrom, Inc. v. Chubb & Son, Inc., 54 F.3d 1424 (9th Cir. 1995). In Nordstom, the court suggests the legitimacy of finding "corporate scienter" without any of the officers or directors of the corporation having intent under a theory of "collective scienter" but acknowledges that "there is no case law supporting an independent collective scienter theory." Id. at 1435. https://digitalcommons.pace.edu/plr/vol25/iss2/9 2 2005] SECURITIES, SCIENTER, & SCHIZOPHRENIA 385 economic justification, and, to some degree, public policy.'0 It is well- settled law that corporations may be held liable for nearly any tortious or criminal activity of an employee, as long as that employee acted within the scope of employment." Thus, corporate liability is often regarded as derivative in nature. 12 However, there has been very little inquiry on whether a corporation itself, without identifiable human involvement, can be a fault-bearing decision-making entity. The threshold question addressed by this comment is whether an organization can exhibit "fault" sufficient to meet requisite elements of scienter for certain violative behavior. The thesis of this paper is that legally significant information regarding "organizational scienter" can be gleaned, not only from the traditional method of imputed behavior from officers, directors, and employees, but also "organizationally," from the internal rules and procedures a corporation uses to interact with its environment. Modem complex organizations have simply become too complicated - too impersonal - not to reevaluate how courts, the legislature, and the law in general view organizational behavior in relation to statutorily-required scienter elements. At first glance, assigning a traditional scienter element (e.g. negligence, recklessness, knowingly or intentionally) to a corporation in the absence of human decision-making, seems antithetical to the precepts and legal assumptions of fault-based law. Traditionally, fault-based law assumes some rational decision-making process by a natural person and an irrational or unreasonable course of conduct before the apportionment of fault.' 3 But large corporations present a special problem in terms of applying traditional fault-based statutes based on derivative liability. By virtue of the inherent anonymity and insulation employees enjoy within highly impersonal organizations, an individual's contribution to injurious corporate behavior is often too tenuous to meet evidentiary burdens of 4 fault-based statutes. ' Only recently, legal reformers began offering more 10. JOHN L. DIAMOND ET AL., UNDERSTANDING TORTS 231-32 (2002). 11. Id. at 231; see also N.Y. Central & Hudson River R.R. v. United States, 212 U.S. 481 (1908) (extending the doctrine of respondeat superior, generally reserved for tort liability, to criminal liability). 12. See generally RESTATEMENT OF TORTS §§ 420-429. 13. See generally UNDERSTANDING TORTS, supra note 10, at 67-77. 14. See generally RESTATEMENT (THIRD) OF TORTS: PRODUCTS LIABILITY § 16 (1998). The Restatement addresses the situation in which the plaintiff establishes increased harm because of a product defect, but proof does not permit determining its magnitude. Id. The Products Liability Restatement imposes liability on the product manufacturer for the entirety of the harm. Id. Thus, the Products Liability Restatement does not require the plaintiff to prove the magnitude of harm caused by each tortfeasor 3 PACE LAWREVIEW [Vol. 25:383 progressive "alternative" theories of liability, akin to those within the "organizational behaviorist" domain. 15 These theories consider the organizational mechanisms that lead corporations to cause harm without help from a significant or identifiable concentration of human involvement.
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